Japanese yen: Under pressure to appreciate

June 30, 2009 12:42 IST

The Japanese yen is appreciating quite stridently in the last few days. One of the key reasons for the yen's recent strength is the uncollateralized overnight call rate, which the BOJ has decided to keep unchanged at around 0.1%, at a time of high-risk aversion amid global crisis.

Although lower rates usually weigh on the currency, because they erode the return on the asset denominated in that currency, the opposite is usually true in times of risk aversion. Whenever the investors get edgy, they tend to shed higher yielding investments funded in the lower yielding currencies.

While the economy is in a difficult situation, the cadence of worsening has become moderate. The Japanese government has raised its assessment of the economy for the first time in three years saying the pace of worsening is slowing as exports and industrial output are nearing bottom. Furthermore, Manufacturing Purchasing Managers Index gave reasons for sanguinity, rising to 41.4 from 33.8 last month.

PMI is the most important indicator of the economic status of a country because it is a reading of manufacturers anticipates, and the May numbers suggest manufacturers anticipate an increase in production in the month ahead. Meanwhile, industrial output surged the most in 56 years, in April 2009.

The Japanese yen became a star performer from the end of 2008, when the global financial catastrophe became significantly visible with the failure, conservator ship of several large United States-based financial firms. Beginning with failures of large financial institutions in the United States, headed by the giant Lehman Brothers, it rapidly evolved into a global crisis resulting in a number of European bank failures and declines in various stock indexes, and significant reductions in the market value of equities and commodities not just in US but practically everywhere. The currency was boosted further as US economic conditions deteriorate further, with the economy slumming by 6.3 per cent in Q4 2008.

The yen hit a historical high of 88 in January 2009, the highest level since the spring of 1995, when the yen had knocked a high of 80 against the dollar. However, the pendulum swung the other way in April 2009 when yen tumbled in value to 100 against the dollar, as the investor's turned their attention to the macro economic fundamentals of Japan, which were not in a good position as evident from the first quarter GDP figures of Japan, as a result of which yen lost its luster. As the yen fell, Japanese exporters benefited, lifting up their shares. Exporters compose an estimated 60 per cent of the benchmark Nikkei index. Yen and the Nikkei have had a strong inverse link since about 2005.

Oflate, Japanese yen is experiencing an up trend, after the government raised its assessment of Japan's economy for the first time in three years. Though the economy shrank at a record 14.2 per cent annual pace in the first quarter, but this contraction is less then previously estimated. The BOJ said Japan's economy is likely to show clearer evidence of leveling out over time.

The government officials are increasingly hopeful that the economy will grow again in the April-June period as the government's stimulus steps take root and companies begin boosting production. The government also raised its view on bankruptcies and public investment as the rise in bankruptcies has moderated and its stimulus spending has boosted contracts for public works.

Given that the current rally in the Japanese currency is auguring on a seemingly strong footing, considering the optimism in the latest BOJ announcement, the underlying pressure on yen to appreciate may remain strong. This is more so the case given that the U.S. net international capital flows dropped to negative $53.2 billion in April. China reduced its holdings of U.S. Treasuries by $4.4 billion to $763.5 billion while Japan also reduced its holdings by $800 million to $685.0 billion. This reflects growing lack of confidence in the US assets and may keep the dollar depressed against yen.

Considering this, there is a very dim likelihood of the BOJ intervening in the forex markets to prevent yen from appreciating further. As the weak yen would not help the economy when there is no overseas demand. On the other hand intervention would lead to excess liquidity in the economy, which in turn will create the pressure on inflation. In an economic sense if the intervention is not sterilized, buying dollars is equivalent to increasing the Japanese money supply, since the Finance Ministry purchases the dollars from Japanese exporters with yen, which then enters the Japanese money supply, in turn showing a road to inflation.